Three Pricing Alternatives For Farmers

Source: Purdue University | Apr 22, 2008

Grain buyers and elevators, like producers, can’t afford to take all the risk and some have stopped offering cash-forward contracts to price new-crop corn, soybeans and wheat, says Chris Hurt, a Purdue University agricultural economist.

Because wet spring weather is delaying the start of Midwest corn planting, Hurt expects to see some good pricing opportunities early this spring for corn and says farmers need to be thinking about new-crop pricing alternatives.

Hurt explains the three primary pricing strategies a broker may outline when pricing 2008 crops.

The first is a simple futures hedge, which involves selling futures as an alternative to a cash contract with the elevator. For example, Hurt says a producer could sell December corn futures for $6/bu. and lock in that futures price. The disadvantage is that producers must deposit a margin and meet margin calls if necessary, without knowing the final basis.

"Margins are like a security deposit," Hurt says. "It's not a cost, it's just a deposit to assure a producer's performance to the broker and the market. It's money that must be deposited and maintained to keep the financial integrity of the contract."

The value of the futures contract is updated daily and all accounts are brought to a zero balance, which is called "mark to the market."

"So, if corn prices rise to $7, the producer has to deposit an additional $1/bu. of margin, which is maintained through the brokerage firm," Hurt says. "On the flipside, if prices were to drop from the original $6 down to $5, the producer would receive $1/bu. of credit in their margin account."

Thus, a producer is obligated to pay for an increase in price or receive benefits from a decrease in price.

The advantage, compared to a cash contract at the elevator, is that a decision can be made later as to which elevator has the best bids, Hurt says. In addition, the basis or range of sale prices is not established until a decision is made of which location to sell to, which means the producer takes a risk.

“Elevators that are still offering new-crop cash contracts have very wide basis bids,” he says. “This may be an advantage of using futures through a broker if those current wide-basis bids improve by the fall.”

The second alternative is to buy put options. Buying put options establishes the right to receive a minimum futures price, but leaves the opportunity for futures price improvement in place, Hurt says.

“This establishes a floor for future prices, but farmers still have the opportunity to receive higher prices if futures move up,” he says. “The primary disadvantage is that producers have to pay a premium to reduce one’s downside price risk, while leaving the upside price opportunity in place.

“Brokers will be able to discuss various levels of downside price protection and outline the costs of this type of strategy.”

For example, December futures for new-crop corn is at $6. A producer would establish a floor at $6 in the futures market by purchasing a $6 put, Hurt says.

A put is the guaranteed right to sell at that price without the obligation.

"So if prices go up to $7-8 they can sell at the higher price," Hurt explains. "If prices were to decrease to $5.50, the producer can still sell at $6 futures because that floor was established."

The disadvantage to this option is that a premium must be paid to get that guaranteed price.

"It's like insurance," Hurt says. "The premium is based on the risk in the markets just like car insurance is based on the risk of the driver. A 16-year-old male will have to pay a much higher premium than a 40-year-old woman. Today the markets are very volatile and there is a lot of market risk, so premiums from any historical perspective are going to be high, but we think they are fairly priced."

The third strategy is called fencing.

"Most people think of a fence as a boundary to keep cattle in, but in this case it is a boundary for prices," Hurt explains. "It establishes a floor for the futures price and a ceiling futures price for upside opportunity."

It combines buying a put for downside futures price protection and selling a call to establish the ceiling futures price. A call is the right to buy at a certain price, which is also known as the strike price.

"The advantage is that producers receive a premium when they sell a call which helps to reduce the cost of this strategy," Hurt says. "The downside is they give away the opportunity to receive a futures price higher than the ceiling."

For example, with December corn futures at $6, a producer might establish a floor on their futures price at $5.80 by buying a $5.80 put, and a ceiling price at $7/bu. by selling a $7 call. This means they are protected on futures prices if they drop 20¢/bu. and more from their current level, but retain opportunity to gain $1/bu. if futures prices move up to $7, he explains.

This strategy also involves a premium. The lower the floor, the lower the premium and if a producer accepts a ceiling, it too will help lower the premium and reduce the cost of this strategy.

Hurt can't stress enough how important it is for growers to work with their commodity advisor and lender to clearly understand the different pricing alternatives.

“Producers need to look at the possibility of having lower prices and higher prices and figuring how they will come out,” he says. “There’s a lot of risk in markets this year and we suggest that producers look at diversified strategies and not bet all of their crop on one strategy – diversify through time and diversify through different types of strategies.

“This will help bring producers back toward the middle. We would all like to be at the top, but this year, with so much uncertainty, we definitely want to avoid the bottom.”

Given the current volatile market swings, prices can change sharply from where producers might sell futures to price their new-crop production and it’s possible producers using futures markets could have large amounts of margin money to deposit.

For this reason, Hurt says it’s imperative for producers who use futures or options markets with a broker to set up a hedging line of credit with their lenders just to cover potential margin calls.

“This line of credit is an assurance that the lender will provide additional funds to meet margin calls if needed,” he says. “This three-way relationship is established between the producer, broker and lender such that each will have all information regarding marketing positions and margin accounts.”